The present invention relates generally to methods and systems for managing portfolios of investments, and more particularly to a method and system for managing a portfolio of investments for smaller investors, in which the investor can manage and limit the risk inherent in the portfolio.
Investors increasingly understand the potential for long-term returns from investments in risky assets, i.e., risky investments can provide better returns over the long term as opposed to the returns from less risky assets. For example, an investment in relatively risky common stocks provides, on average and over the long term, a higher return than an investment in a money market account. Unfortunately, risky assets carry risk. Although over time and on average the returns on risky assets may be higher than those of less-risky assets, their returns are more volatile. An investor who wishes to ensure that a certain amount of investment will be preserved as of a specified time has no certainty with risky assets that such preservation will be achieved.
As an example, an investor that purchases a common stock for $100 has no assurance that in five years that share of common stock will be worth $100. By contrast, an investor that buys a 5 year Treasury note with a principal amount payable at maturity of $100 knows that (with almost 100% certainty), at the end of the five years, the note will pay precisely $100. For this reason, investors are frequently provided with advice to the effect that they should place their investments in different risk classesxe2x80x94usually short term (non-risky), intermediate term (some limited risk) and long term (risky). Under this structure the riskiness of long-term investments presumably provides a boost to overall expected returns while the probable preservation of value in the less risky part of the portfolio ensures that short-term cash needs can be satisfied. This advice attempts, at one level, to take into account the concept of risk, and reflects the general notion that risk is correlated with returns: the higher the risk, the higher the expected returns, and vice-versa.
There are a number of different ways of thinking about or characterizing types of risk. One type of risk is known as firm specific risk (which is relative to an individual company), which is closely related to firm credit and/or default risk. Very generally speaking, these are the risks that, if equity or debt, the share price will be highly volatile as opposed to relatively stable and the risk, if equity or debt, that the investment in the entity will not be repaid. Another type of risk, known as market risk (which is separate from the risk of any firm specific risk) is the risk that the relevant xe2x80x9cmarketxe2x80x9d as a whole will increase or decrease in value; the specific value of an investment may be correlated, to varying degrees, with xe2x80x9cthe market.xe2x80x9d Yet another type of risk, known as liquidity risk is the risk that the investment can be paid or liquidated on short notice. There are many other risks as well, and different ways of thinking about these risks. While the present invention discusses these three types of risk, it is not limited in application to these three types of risk.
Assets suggested as short term investments generally are low risk from a variety of perspectives. First, the investment will be safe as to principal amount (e.g., the investment has low credit risk). Second, the investment will fluctuate little if at all relative to the market or to interest rates or other general economic variables (e.g., the investment has low market risk). Third, the investment will be available when needed on short notice (e.g., the investment has low liquidity risk).
Examples of short-term investments abound, ranging from traditional banking vehicles, such as passbook savings and interest-bearing checking accounts and short-term certificates of deposit, to short-term government bonds, to short-term highly rated corporate notes, to open-end mutual funds invested in such instruments (e.g., xe2x80x9cmoney market mutual fundsxe2x80x9d) and funds investing in guaranteed bonds with short durations, etc. In this range of investments, rates of return are traditionally low, thus reflecting the low overall risk of the investments.
Medium and long-term investments generally have additional firm specific, market or liquidity risk. With higher levels of such risk, investors demand higher returnsxe2x80x94which increases the cost of capital. Consequently, ever since investments were created efforts have been made to reduce these and other risks for investors. Such risk reduction would potentially attract a greater supply of capital to these investments, thereby lowering the returns demanded by investors and potentially lowering the cost of capital.
Firms can reduce liquidity risk by fostering a ready market for their securities. The advent of the traditional secondary trading markets has significantly reduced liquidity risk for publicly traded securities, which is part of the attraction of the public markets. Liquid secondary markets also reduce liquidity risk for various non-publicly-traded securities, such as open-end mutual fund shares. Specifically, liquid secondary markets enable open-end mutual fundsxe2x80x94whose shares do not trade publiclyxe2x80x94to provide liquidity to their shareholders (the individuals and institutions that invest through mutual funds). Because the fund can liquidate quickly some of its holdings to pay shareholders who wish to sell shares in the fund, the fund can, in essence, xe2x80x9cmake a marketxe2x80x9d in their own shares and guarantee liquidity to these holders by redeeming their interests in the fund for cash the next day at net asset value. If the funds faced an illiquid market for their own holdings, it would be much more difficult for them to guarantee liquidity to their own shareholders.
Efforts at reducing credit risk are extremely varied. Credit risk has been reduced by various types of credit enhancements, ranging from establishing trusts with collateral, to having larger institutions or more financially sound institutions guaranteeing the obligations of a more risky issuing entity, to limiting investments to those investigated and rated highly by others (such as SandP investment grade ratings), to imposing legal covenants and restrictions on the issuer designed to maintain credit-worthiness and, of course, the best credit enhancer of all, a direct or indirect U.S. government guarantee (such as the government guarantee in connection with federally-insured banks and savings institution deposits). These measures, to the extent credit risk is perceived as a major issue, are reasonably successful, even if, at times, they are not well priced. Of course, credit risk is also reduced somewhat by size, the larger and more profitable a firm, generally the less risky; and by the firm""s own mix of businesses so that it may be less susceptible to a downturn in any one business area and thereby be less risky than if it was concentrated and focussed in just one business.
As discussed, firms embody a variety of firm specific risks. In addition to these mechanisms for reducing the credit/default type, liquidity and other risk associated with a specific firm, it has been generally well known and accepted that an investor can reduce firm specific riskxe2x80x94but not market riskxe2x80x94with regard to securities by creating a portfolio that is diversified.
Mutual funds have increasingly been the vehicle of choice through which smaller investors"" have diversified their investments, but such funds have a number of significant disadvantages as compared to acquiring direct ownership of the securities themselves. (U.S. patent applications Ser. Nos. 09/038,158 and 09/139,020 filed by the same inventor discuss in detail the disadvantages of mutual funds, which applications are hereby incorporated by reference in their entirety, including the drawings, as if repeated herein.) Nevertheless, market risk in a portfolio of equities, for example, is not eliminated, even when diversification, whether through funds or in a directly-owned diversified portfolio, reduces or eliminates firm specific risk.
Consequently, a vast number of products, services and techniques have been developed in attempts to reduce (as opposed to avoid) market risk. An example of such a product, service and technique is hedgingxe2x80x94such as buying put options on an index to hedge against decreases in value in a portfolio that reasonably matches the index (such as by using a LEAP that provides some protection for up to three years on various stocks or indices).
An example of a service combined with a technique was xe2x80x9cportfolio insurancexe2x80x9d which was a failed attempt to reduce risk by selling futures on a basket that reflected the ownership of the underlying securities to place, in essence, a stop limit on the expected decrease in value of the portfolio. All these mechanisms generally involve short-term actions, great sophistication, high costs for small portfolios and are not available as cost-effective solutions to decrease market risk over the long-term for smaller investors.
Other mechanisms, however, have been developed that are useful for smaller investors to reduce various types of market-related risk over the longer-term. One example of these mechanisms includes instruments that contain economic adjustments, such as resets of interest rates or conversion features to try to maintain some specified value when market rates change. Another example of such a mechanism is a guaranteed investment contract (similar to a bond, but redeemable at any time or at particular windows at par so that it has no market risk). Another example of such a mechanism is a xe2x80x9creal ratexe2x80x9d bond that is issued by the U.S. Treasury that provides an inflation-adjusted return and carries no credit, liquidity or market risk. Still another example of these mechanisms is a vehicle like Merrill Lynch""s Market Index Target Term Security (MITTS(copyright)) (described more below). Finally, another example of these mechanisms is a mutual fund that attempts to cushion against market risk by balancing its portfolio with bonds, cash and other assets expected to have lower market risk. Still another example, is a program offered by Prudential Insurance and Prudential Securities where an investor purchases one of various selected Prudential managed mutual funds and then purchases life insurance. When the investor dies, the life insurance makes up any reduction in value in the selected mutual fund investment. This program is similar to programs where an investor or an insured obtains life insurance to pay a mortgage amount or other amount. All of these investment vehicles or systems are specific alternative investments for investors or have certain limitations (such as the investor must die), not products, systems or methods for a small investor to decrease the risk of an investor-selected or already owned portfolio.
The MITTS-type of security is issued by an entity, such as a brokerage like Merrill Lynch or a bank or an insurance company, and works as follows: The security will be issued for a specified pricexe2x80x94such as $10 per share. The security is then guaranteed to pay a minimum specified price, usually the initial offering price ($10 here) at some point in the future, such as five years from the date of original issue. In that regard, it is just like a five-year note with the specified repayment of principal. But in addition to paying the principal, and in lieu of paying interest during the term of the note or at the end, the instrument pays a xe2x80x9csupplemental payment.xe2x80x9d That payment is a specified amount, such as a percentage of the increase in a specified stock index (e.g., the SandP 500), during the term of the security. Consequently, if the security is paying xe2x80x9c75% of the percentage increase in the indexxe2x80x9d, then at the maturity of the security if the index has doubled (up 100%) the holder would receive principal of $10 plus a supplemental payment of $7.50 ($10 times 75% of 100%). If the index had decreased or remained unchanged the holder would receive the guaranteed $10.
Some other possibilities exist, for example, other different possible indices can be chosen, or the security could even be linked to just one other security. Moreover, supplemental payments could include any percentage, including a percentage in excess of 100%, with various minimums or maximums on the supplemental payment. Furthermore, the security could be sold at more than par when issued thereby resulting in potential, but limited, losses, etc.
These instruments have a variety of disadvantages:
All these instruments are distinct securities. In order to provide liquidity for the holder, they must be standardized and listed and traded on various exchanges. Consequently, although there are an unlimited number of variants for these types of securities, and in fact there are many of them currently outstanding, they are limited to those issued by sponsors who will engage in the effort and the expense of registering, listing and selling them to the public.
Since these instruments must be bought, an investor must either have cash that was uninvested or be willing to sell some other investments to raise the cash to acquire these securities.
These securities typically do not provide for any flow-through of dividends, or voting rights.
Because they are traded, they have a currentxe2x80x94and changingxe2x80x94market value during their term. Although they are guaranteed as to their minimum payout at the end of their term, their value fluctuates during their term. As an example, an instrument that is linked to an index that is currently materially below its reference level (if the reference level were 100, the current level could be, say, 75) will trade at a discount to its par value, such as $8 in the above example, because the instrument might reasonably be expected to pay only $10 in a few years and a reasonable investor would not pay more than $8 now for the right to receive only $10 in a few years. Consequently, an investor who wishes to sell the instrument now will lose $2 (20% of her investment).
Similarly, the instrument could be trading at a current premium, such as $12, if for example, the index has performed well to date (say at 110 where the reference level was 100). In that instance, any new purchaser of the unit will be incurring some risk of loss. For example, if the index at maturity decreases below the reference level of 100, she will receive only $10, for a loss of $2, although her loss is capped at that $2 amount because she will receive at least $10.
These instruments do not enjoy favorable tax treatment. Returns earned by investors are ordinary interest income, even if the security is sold prior to maturity, and tax will generally be levied on imputed income annually, even though the cash is usually paid only at maturity. Consequently, these instruments are useful almost exclusively for tax-favored accounts, like retirement accounts. Of course, those are precisely the accounts where investors can incur greater levels of risk because they are usually longer-term investments, and where this type of security is less necessary.
Since these instruments are sold as securities, through brokers, commissions are levied.
Finally, again, these are separate instruments for investing, they are not methods or systems that can be used to reduce the market risk in an already existing portfolio of securities.
Most of these disadvantages are shared by the other existing methods of limiting downside risk described above. For these reasons, among others, these alternatives have not been that useful or popular for investors in reducing their downside risk exposure to the marketplace. Therefore, investors who are concerned about the stability and volatility of the marketplace sometimes sell their equity portfolios when the market is unstable. Other investors who know they should invest in the market in order to obtain the returns they would like to achieve over the long term may nevertheless invest less in the market than they otherwise would, even when the market is stable, out of concern that the market, and therefore their investments, will decrease in value. If investors were insured against some of the downside risk in investing in these risky assets, they would find it easier to maintain their current investment portfolios in light of market instability. Under such circumstances, investors might even increase the percentage of their portfolios allocated to riskier assets even when the market is unstable.
Unfortunately however, to date, it has been impossible, on a cost-effective basis, to price a hedge for a small portfolio on a dynamic basis and provide the interactivity necessary for the hedge to be useful to a smaller investor. There has not been the embodiment in a computer-and-Internet-based system of a whole new product that allows for the creation of a hedged portfolio resulting in a smaller investor being able to limit the downside risk of an existing portfolio of investments.
The present invention is therefore directed to the problem of developing a method and system for providing a smaller investor with a portfolio of investments a way to manage the risk underlying the investor""s portfolio.
The present invention solves this problem by combining a graphical or other user interface accessible by the investor over the Internet or through an intermediary with a computational pricing mechanism that examines an investor""s current portfolio""s expected risk, prices the expected risk, and transfers to a third party all or some of either that precise expected portfolio risk or some other more general or different risk, such as overall market risk as reflected in an index like the SandP 500. The third party may be the system operator. The transfer is in exchange for consideration, which can be either cash, other property or part of the opportunity cost forgone in connection with the portfolio.
According to the present invention, a computer-based system for managing risk underlying a portfolio of assets/liabilities, includes a graphical user interface, a memory (with a custodial feature), a processor and a link to the party incurring the risk, which could include the public markets through publicly traded hedging devices such as puts and calls. The graphical user interface enables the user to enter information about the portfolio, including a list of assets/liabilities, values for each of the assets/liabilities, shares owned or a percentage of each issue as part of the entire portfolio, and an input of what the user wishes to have limited for downside risk (xe2x80x9cshielded or protectedxe2x80x9d). The memory with the custodial feature stores the portfolio to be shielded. The processor analyzes the portfolio using, among other known techniques, value-at-risk and sensitivity algorithms and probabilistic analysis to determine an expected likelihood of a catastrophic loss in value at a plurality of specified levels and a likely distribution of outcomes for the portfolio over specified periods, and can also calculate the cost of hedging the risk through the purchase of instruments traded in the public markets. Furthermore, the processor provides a series of choices to the user via the graphical user interface to select: (i) a time period or periods for which the user seeks shielding from market risk for the portfolio, (ii) a degree of market risk protection, said processor pricing the requested shielding including by reviewing the cost of hedging, and (iii) a menu of pricing mechanisms. The linkage to the third party incurring the risk can be an internal linkage if the system operator will be incurring the risk directly, or to an independent third party such as an insurance company, a hedge fund, or another party that is incurring the risk (including the public markets if the risk is hedged through publicly traded instruments), etc.
According to the present invention, the portfolio to be shielded for the investor can be a portfolio that is devised by the computer-based system and executed and transacted for the user, or is separately transferred to the system from another brokerage, bank or intermediary, or is otherwise transferred by the user to the system.
According to another aspect of the present invention, the degree of market risk protection that an investor can select would include full protection, partial protection, excess protection, indexed protection or variations in between or any combination thereof. Full protection means no decrease in value from the current value. Partial protection means no more than a specifiable decrease, such as 10%, in value from a current value. Excess protection means that the portfolio value will increase in value and provide at least a specified return, which could be either a specified rate such as the nominal inflation rate, or the real inflation rate on a going forward basis (in other words, whatever the inflation rate is over the specified period for which the shielding is in effect), or reflecting a specifiable dollar or percentage amount that is specified and fixed at the time the shield is acquired. Indexed protection means protection limited by, relative to or otherwise related to, an index, which could be a single other security, a customized group of securities or a standardized index like the SandP 500.
According to the present invention, the processor prices the shielding in a variety of different manners. As described more fully below, the variety of pricing manners includes for a shield to be provided over a specifiable term: (i) a dollar amount payable at the time of obtaining the shield or payable at the end of the shield period or at other times in between, (ii) a percentage (including a variable percentage) of any portfolio value increase (or increase relative to an index or some other value) over the specified period (a xe2x80x9cvertical slicexe2x80x9d or assignment), wherein if the portfolio does not increase in value, the user owes nothing (but still receives the requested protection so that if the portfolio value is not at least at the level specified by the shield the user is shielded and receives whatever amount is necessary to bring the portfolio value back to the shielded value), but if the portfolio increases in value the agreed-upon specified percentage or amount of the portfolio value increase is paid as the premium for the shield, (iii) an amount over or within some specifiable level of return (a xe2x80x9chorizontal slicexe2x80x9d or assignment) that would otherwise work similarly as in (ii), or various combinations of (i), (ii) and (iii).
According to another aspect of the present invention, the graphical user interface receives input from the user regarding the protection desired and the payment method, and the securities shielded are then held in the memory with the custodial feature.
According to yet another aspect of the present invention, the system links with a third party willing to incur the risk of shielding the user portfolios and either provides information to the third party as it is received from users so that the processor remains resident at the third party, or obtains information from the third party as to the third party""s charges for ranges of shields and uses that information to price the shields (so that the processor remains resident with the system operator).
According to yet another aspect of the present invention, the system linkage is with multiple third parties who provide competing quotes for their willingness to shield specific user portfolios so that the user can obtain the best price for the shielding and with market makers and others offering publicly traded instruments that could be used to create a dynamic hedge for the system operator to shield the portfolio.
According to another aspect of the present invention, the dividends paid on the securities in the portfolio and cash on securities that are cashed out in acquisitions are either payable to the user or reinvested in the portfolio pro rata with slight pricing differences depending on which pricing and what shield option the user selected.
According to yet another aspect of the present invention, if the user wishes to sell a part of the portfolio pro rata but otherwise wishes to maintain the balance of the portfolio, then depending on which payment mechanism the user selected, the user may either be refunded some of the premium paid, have to pay some of the returns to date, and/or be charged a dollar amount as a deferred premium.
According to yet another aspect of the present invention, if the user wishes to sell selected securities in the portfolio, and thereby change the mix in the portfolio, the processor either: (i) re-prices the remaining shield on the new portfolio and calculates a differential, (ii) advises the user via the graphical user interface to replace the sold security with another security with sufficiently similar portfolio characteristics, and provides a list of such securities, or (iii) terminates the shield outputting a required payment amount to the user via the graphical user interface.
According to the present invention, a method for managing risk underlying a portfolio of assets/liabilities, includes the steps of: a) receiving information about the portfolio from a user, including a list of assets/liabilities, current market values for each of the assets/liabilities, amount of each asset/liability (e.g., shares owned or a percentage of each issue as part of the entire portfolio), and an input of what the user wishes to have limited for downside risk (xe2x80x9cshielded or protectedxe2x80x9d); b) storing the portfolio to be shielded; c) analyzing the portfolio using value-at-risk and sensitivity algorithms and probabilistic analysis to determine an expected likelihood of a catastrophic loss in value at a plurality of specified levels and a likely distribution of outcomes for the portfolio over specified periods or calculating the cost of shielding the portfolio through publicly traded instruments; d) providing a series of choices to the user via the graphical user interface to select: (i) a time period or periods for which the user seeks shielding from market risk for the portfolio, and (ii) a degree of market risk protection; and e) pricing the requested shielding and providing said pricing to the user.